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Optimal Policy with Low-Probability Extreme Events

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  • Lars E.O. Svensson

Abstract

The optimal policy response to a low-probability extreme event is examined. A simple policy problem is solved for a sequence of different loss functions: quadratic, combined quadratic/absolute-deviation, absolute-deviation, combined quadratic/constant, and perfectionist. The paper shows that, under some simplifying assumptions, each of these loss functions puts less weight on a low-probability extreme event than the previous one, down to the quadratic/constant and perfectionist loss functions, which completely ignores the low-probability extreme event. The case when the size of the extreme shock is endogenous and depends on the policy is also examined. This introduces an additional effect on the optimal policy except for the combined quadratic/constant and the perfectionist loss functions.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10196.

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Date of creation: Dec 2003
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Handle: RePEc:nbr:nberwo:10196

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  1. Svensson, Lars E. O., 1999. "Price Stability as a Target for Monetary Policy: Defining and Maintaining Price Stability," Working Paper Series 91, Sveriges Riksbank (Central Bank of Sweden).
  2. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," NBER Working Papers 10195, National Bureau of Economic Research, Inc.
  3. Charles Goodhart & Margaret Bray, 2002. "You Might as Well be Hung for a Sheep as a Lamb: The Loss Function of an Agent," FMG Discussion Papers dp418, Financial Markets Group.
  4. Lars E.O Svensson, 2002. "Monetary policy and real stabilization," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 261-312.
  5. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
  6. Margaret Bray & Charles Goodhart, 2002. "You might as well be hung for a sheep as a lamb: the loss function of an agent," LSE Research Online Documents on Economics 24937, London School of Economics and Political Science, LSE Library.
  7. Kenneth F. Wallis, 1999. "Asymmetric density forecasts of inflation and the Bank of England's fan chart," National Institute Economic Review, National Institute of Economic and Social Research, vol. 167(1), pages 106-112, January.
  8. John B. Taylor & Chair, 2002. "General discussion : monetary policy and real stabilization," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 319-331.
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Cited by:
  1. Waters, George A., 2007. "Regime changes, learning and monetary policy," Journal of Macroeconomics, Elsevier, vol. 29(2), pages 255-282, June.
  2. Disyatat, Piti, 2010. "Inflation targeting, asset prices, and financial imbalances: Contextualizing the debate," Journal of Financial Stability, Elsevier, vol. 6(3), pages 145-155, September.
  3. Katerina Smidkova, 2003. "Methods Available to Monetary Policy Makers to Deal with Uncertainty," Macroeconomics 0310002, EconWPA.

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